How to Value Common Stock given Required ROI (Return on Investment) and Dividends
Shares of common stock are more difficult to value than say a bond payable because of three inherent reasons:
Deriving the Common Stock Valuation Formula
Having said this, how can we value common stocks and discount them for the present values? Imagine that you buy a share of common stock today and plan to sell the stock in one year. From insider knowledge, you know that the stock will be worth $80 in one year. You also think that the stock will pay $8 per share dividend at the end of the year. If you require a 15% return on your investment, what is the most you would pay for this stock as of now? In other words, what is the present value of the $8 dividend along with the $80 ending value of the stock at 15% required rate of return? Here’s how to calculate this:
Therefore, the perceived present value of this investment will be $76.52 today. This formula can be put in more explicit terms as follows:
From a report on a popular financial blog, you know that a stock will pay $12 per share dividend at the end of 2009 and will be worth about $105 on December 31st, 2009. If you require a 20% return on your investment, what is the present value of this stock that you would be willing to pay?
Therefore, we know from this that a stock that will be worth $105 and will pay $12 dividend at the end of the year is presently valued at $97.50 at a discount rate of 20%.